Demand for commercial real estate capital has increased nationwide in the past few years. Regulations implemented after the financial crisis a decade ago, however, have led banks to use more cautious lending strategies.
Leading up to the crisis, commercial mortgage-backed securities (CMBS) were increasingly used as a financing option, but their structural features were unable to save borrowers from the larger systematic failure that took place. Today, scrupulous commercial mortgage brokers can learn a lesson and save their clients from similar situations by helping them to identify suitable long-term windows of opportunity, not just short-term optimization.
Many new and renewed forms of alternative lending have emerged to supply the necessary financing for commercial real estate projects nationwide — some of which appear to be quite inexpensive. Although the additional capital is much needed and the terms may seem compelling, mortgage brokers should take care to scrutinize these opportunities. Rising interest rates and the maturation of the real estate cycle may make these financing options seem less compelling to your clients.
Savings and loan (S&L) institutions, also known as thrifts, dominated the commercial real estate financing industry until the S&L crisis of the 1980s and 1990s, when thousands of thrifts failed nationwide. The modern CMBS market — which involves pooling mortgages and issuing securities backed by the revenue streams from those mortgage pools — was born from efforts to liquidate the assets of failed thrifts.
For borrowers, improper use of leverage can cause them to be unable to obtain future refinancing on the same property.
The CMBS structure was employed to pool large numbers of mortgages into a single issuance. It also was designed to address the sheer number of mortgages that needed to be processed, as well as transfer risk from the lender to the bondholder. In the subsequent decades, CMBS financing seemed to have structural advantages to protect both the borrower and the lender.
Nonbank CMBS
In the past few years, CMBS financing has begun to regain footing in the lending landscape, although new rules are in place. The originator and securitizer of the loan has to retain “skin in the game,” meaning that they must hold onto some of the loan risk. Despite this regulation, CMBS issuance in the U.S. exceeded $87 billion in 2017, up 27 percent from 2016.
Many investors agree that volume is likely to be slightly lower in 2018, however. Although the market has adapted to the risk-retention rules, sourcing new loans could become a bigger challenge as industry growth slows. The credit quality of new loans also could be compromised by decreasing property values and rising capitalization rates.
These factors could lead to a decrease in the overall quality of CMBS issuances. Lenders that originate and retain a piece of the CMBS issuance also may face challenges this year. If the market reaches capacity and lenders are unable to sell the pieces they hold, they could face liquidity issues.
Debt and alternative funds
Debt funds, often backed by foreign investors, are starting to play an increasingly important role in the alternative-lending space, offering bridge and mezzanine loans for borrowers who seek more permanent financing. North American-focused private-equity real estate debt funds raised $18.3 billion in 2017, nearly double the $9.9 billion raised two years earlier. Much of this financing is coming from foreign lenders, who have a lot of dry powder, or cash reserves, they are looking to deploy.
Foreign-investor debt strategies are typically a mixed bag that include higher-yield mezzanine and bridge-loan funds, as well as more conservative senior loans. In the rising interest rate environment, some see debt strategies as less risky, since their investors are less vulnerable to major losses than equity investors if a property’s value falls.
The credit quality of new loans also could be compromised by decreasing property values and rising capitalization rates.
Borrowers and brokers must consider, however, that debt funds ultimately operate through the deployment of capital to their investors when they make a loan. This means that even if a debt fund’s investment is not lucrative, the fund managers still make money through a management fee. Fund managers wishing to deploy abundant dry powder also may be less meticulous in terms of the investments they make.
A number of nonbank lenders offer balance-sheet financing options, which are proprietary lending products structured by in-house experts. These companies assume the most risk when they issue loans because they use their own money to provide the financing. Because these nonbank lenders have more skin in the game, they are less likely to offer flexible and aggressive terms, and more likely to be cautious regarding the properties they are willing to finance.
Nonbank lenders, however, still provide numerous bridge- and mezzanine-loan programs that will allow a borrower to eventually transition to a more permanent financing structure. These lenders are among the most incentivized to perform well because of the losses they will incur if they don’t.
Potential pitfalls
There are three financing factors that a mortgage broker should consider when assessing a lender’s capabilities: leverage, credit and loan structure. Failing to consider leverage and credit, in particular, could lead a client to lose a great deal of his or her own capital, and thus lose faith in the mortgage broker.
Leverage. Responsible lenders will take care to ensure they do not overleverage their loans. Although most property owners use some leverage, those who are reckless borrow more money than they will be able to pay back if they do not receive the expected return from the property’s income. Overleveraging can happen if a lender fails to accurately assess risk or shows a lack of regard for the risk they are undertaking. For borrowers, improper use of leverage can cause them to be unable to obtain future refinancing on the same property.
Credit. When lenders assess financing opportunities, they should take care to ensure the assets they are underwriting are creditworthy. While some lenders may be willing to provide a loan on a subpar property, other lenders will make sure the loan terms match the quality and price of the property. Although a borrower may be tempted to accept financing on such a property, the asset may ultimately be worth less than the loan that was issued. In such cases, the borrower may lose the asset or, in order to keep it, may be forced to pay more than the property is worth.
Loan structure. Borrowers and brokers should be wary of financing structures that do not protect the borrower if the property’s value drops. Although a loan structure generally exists to protect a lender, diligently structured loan terms also can encourage a borrower to remain vigilant regarding the basis and economic performance of an asset. Ultimately, an engaged borrower will better maintain and manage an asset, preserving its value and maximizing its cash flow.
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As inexpensive capital continues to proliferate, some undisciplined lenders may be engaged in a race to the bottom. The fallout of this practice may eventually affect a mortgage broker’s clients. In the interest of maintaining strong, long-term relationships with borrowers, brokers should carefully recommend financing options that not only work in the moment, but over the long term.
